The Bank of England has warned of "severe strains" in financial markets and told banks they should cut staff and axe any dividend payouts to shareholders to boost their capital cushions.

But at the same time the Bank's new Financial Policy Committee appeared to concede that banks might need to eat into their capital cushions to keep credit flowing into the stagnating economy.

The second report by the FPC – set up by the coalition inside the Bank to be responsible for financial stability – shows it has considered the need for "short-term measures" to try to prevent a re-run of the 2007 credit crunch.

In a two-page update of its latest meeting, on 20 September, the FPC said: "The committee had advised UK banks in June that, if their earnings were strong, they should seek to build capital levels further, given the risks to the economic and financial environment. But events had lowered the likelihood that banks would be able to strengthen their balance sheets in this way over the short term."

Even so, the committee said it was recommending banks take "any opportunity" to strengthen their capital and stock of liquid assets to "absorb flexibly any future shocks without constraining lending to the wider economy". This could be done by raising long-term funds on the markets and reducing dividends and bonuses in line with any fall in profits.

The Bank's quarterly credit conditions survey, issued alongside the committee's report, said lenders were warning that the shaky state of financial markets could constrain credit in the coming months. The credit conditions survey showed that the supply of loans to households increased modestly in the third quarter of the year, while the availability of lending to businesses was flat; but, "lenders pointed to adverse wholesale funding conditions as a key factor which might constrain future lending".

The FPC, which is chaired by Bank governor Sir Mervyn King, also advised the Financial Services Authority to encourage banks "to manage their balance sheets in such a way that would not exacerbate market or economic fragility".

"For example, at the present time, some actions taken to raise capital or liquidity ratios could potentially worsen the feedback loop between the financial sector and the wider economy and so should be avoided," the committee said.

After its first meeting in June, King described the eurozone as posing the "most serious and immediate" single threat to financial stability and the committee acknowledged that since then there had been "severe strains" in financial markets.

The FPC does not yet have powers to intervene in markets but spelled out some of the powers that it would like to be able to deal with the crisis, including the ability to intervene on bank balance sheets and putting limits on loan-to-value ratios on mortgages.

It also urged the Treasury to resist attempts by the EU set a maximum threshold for capital ratios which might prevent it from requiring banks to hoard even more capital than the regulatory minimum,